The last couple of years have been rough for real estate, but there was a time not too long ago when it seemed that this was a ‘special’ asset class, with real estate investment trusts (REITs) providing valuable diversification benefits and consistently high returns.  Do today’s low valuations represent an opportunity to buy?  Can investors expect a return to low correlations for REITs with the major equity market indexes?

Commercial real estate has not collapsed to the same degree as the residential market.  Has the REIT market priced in a likelihood of a similar collapse, and subsequent defaults, in the commercial sector?  If so, what are the risks to REIT investors today?

My proprietary Monte Carlo analysis provides a useful framework for answering these questions.  By comparing risk metrics among REITs before and after the collapse of the real estate market, we can see how dramatically things have changed and assess the likelihood that REITs will return to their “special” status.

The answers are not encouraging for REIT investors, and I offer my assessment of what now constitutes an appropriate allocation to this asset class.

In March of 2007, I published an analysis that suggested that REITs were vastly over-valued.  A month later, I wrote an article that related the over-valuation in REITs to the over-valuation in residential real estate.  In the two and a half years or so since these articles were published, the real estate market has experienced a substantial correction.  In this article, I look at REITs from a broader perspective that combines tactical and strategic considerations. 

The changed landscape for REITs

With trailing three-year average annual returns in the double-digit negatives for REIT-based index funds like ICF and RWR, are REITs now substantially undervalued?  Further, have the broad increases in correlation across asset classes affected the value of REITs as a diversifier? 

Let’s start by looking back three years to the height of the real estate boom.  The trailing returns for REITs were stunning, and the Betas were low.  The table below shows the trailing returns and risk metrics for three large REIT index funds, from Vanguard (VGSIX), iShares (ICF), and SPDR (RWR).  3 years

This table includes major equity classes for comparison.  As July 2006 drew to a close, the Betas of all three of these REIT index funds were below 1.00 with respect to the S&P500.  A Beta greater than 1.means that a fund amplifies swings in the S&P500 (while less than 1 indicates a dampening effect).  Even back in July 2006, the trailing volatility of these REIT funds (measured by the Standard Deviation in Return) was at least twice that of the S&P500.

Back in the summer of 2006, the correlations between REITs and the major equity asset classes were also quite low (see table below). 

Correlations for 3 years

The correlations of ICF, RWR, and VGSIX to large cap domestic stocks (SPY), small cap stocks (IWM), and international stocks (EFA) were consistently below 50%.  These levels of correlation meant that REIT funds had the potential to be effective diversifiers.  The challenge for investors figuring out how much exposure to REITs they wanted lay in balancing three factors:

  1. the attractive diversification properties of REITs
  2. the high volatilities associated with REITs
  3. the tactical considerations of buying REITs after years of very high returns